Underrating the Magnificent Seven’s Concentration Risk
10 January 2024
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All fields required where indicated (*)It’s an astounding fact that Apple’s stock ended 2023 with a market value of $3 trillion. That’s more than the value of Italy’s entire economy, which is about $2.6 trillion.
Comparisons such as this often mark the peak in bubble markets. For instance, at the height of Japan’s bubble economy in the 1980s, the Imperial Palace in Tokyo was worth as much as the entire US state of California. Indeed, Tokyo real estate could sell for as much as $139,000 per square foot, nearly 350 times as much as similar space in Manhattan.1 What followed, though, was a collapse of the bubble in the 1990s.
That’s not to say Apple and its fellow Magnificent Seven (Mag7) US technology stocks are riding for a fall. But they are highly valued at a time when investors all around the globe have a lot of their wealth tied up in them. To my mind, this is one of the greatest risk factors facing investors in 2024. What’s more, it shows that equally-weighted stock market indices are far more effective at diversifying risk than the conventional capitalization-weighted indices.
Equal-Weighted Versus Market Capitalization-Weighted Indices
Let me explain. Last year was exceptional for the buzz around the Mag7. Apple, Microsoft, Alphabet, Amazon, Tesla, Meta and Nvidia were brought together by the loose theme of generative artificial intelligence, as well as the likely resilience of their earnings at a time when interest rates were high.
By the end of the year, this small group had risen in price by more than 100%. That has left the stock markets’ traditional capitalization-weighed indices unusually concentrated and dependent on the fortunes of just seven highly valued stocks. Take the US: at the end of 2023, the Mag7 made up 28% of the S&P 500 by value.2 Even in global markets, these US tech stocks dominated. They made up 19% of the MSCI World Index.3
Comparing stock market indices more generally, it’s plain to see that the problem of excessive concentration goes beyond the Mag7. A common measure of equity market concentration is called the Herfindahl-Hirschman Index.4 The inverse of this index is sometimes referred to as the “effective” number of stocks. This measure suggests that although the MSCI World Index includes 1,480 stocks, in fact the ‘effective’ number of stocks is just 131.
By contrast, the equally-weighted index that our VanEck Sustainable World Equal Weight UCITS ETF tracks includes just 251 actual stocks yet holds an ‘effective’ number of 241. In other words, counter-intuitively the equal-weighted index with the smaller number of holdings delivers more risk diversification than the market capitalization-weighted MSCI World Index.
Actual Versus Effective Number of Stocks
Source: Morningstar
After 2023’s banner year for the Mag7, it’s also true that the MSCI World is largely weighted towards North America, as the chart below shows.
Regional Exposure
Source: Morningstar
Avoiding the Problem
The episode of the Mag7 has served a useful purpose in revealing the shortcomings of using market capitalization-weighted benchmarks for investing.
Everything may not be as perfect as it seems, though. After the initial euphoria about generative AI’s possibilities, 2024 will be the year when it needs to justify the hype. All it will take is some of the Mag7 to miss earnings forecasts, or doubts to creep in about the practical usefulness of this new technology, for pain to be inflicted on investors worldwide.
We think that the dominance of the Mag7 subjects investors to the risk of just a few companies – just what stock market indices are meant to avoid. The flaws of traditional market indices are that they underrate concentration risk: we established our global equally-weighted ETF and its European equivalent, the VanEck Sustainable European Equal Weight UCITS ETF, precisely to avoid this problem. However, other risk factors need to be considered before investing in this fund, as outlined in the ETF´s documentation.
1 Source: SCMP. https://www.scmp.com/magazines/style/news-trends/article/3091222/japan-1980s-when-tokyos-imperial-palace-was-worth-more
3 Source: Morningstar. An ETF is used as a representation of the MSCI World Index.
4 Source: Wikipedia. https://en.wikipedia.org/wiki/Herfindahl%E2%80%93Hirschman_index
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This is a marketing communication. Please refer to the prospectus of the UCITS and to the KID before making any final investment decisions.
This information originates from VanEck (Europe) GmbH, which has been appointed as distributor of VanEck products in Europe by the Management Company VanEck Asset Management B.V., incorporated under Dutch law and registered with the Dutch Authority for the Financial Markets (AFM). VanEck (Europe) GmbH with registered address at Kreuznacher Str. 30, 60486 Frankfurt, Germany, is a financial services provider regulated by the Federal Financial Supervisory Authority in Germany (BaFin).
The information is intended only to provide general and preliminary information to investors and shall not be construed as investment, legal or tax advice VanEck (Europe) GmbH, VanEck Switzerland AG, VanEck Securities UK Limited and their associated and affiliated companies (together “VanEck”) assume no liability with regards to any investment, divestment or retention decision taken by the investor on the basis of this information. The views and opinions expressed are those of the author(s) but not necessarily those of VanEck. Opinions are current as of the publication date and are subject to change with market conditions. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results. Information provided by third party sources is believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. Brokerage or transaction fees may apply.
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